Exploring trust dynamics in finance: the impact of blockchain technology and smart contracts

In the digital age, trust among individuals finds its manifestation through contractual agreements, as illustrated in Fig. 2. Financial transactions, at their core, arise from the fundamental human need to exchange value. The nature of the assets involved in a financial transaction plays a pivotal role in determining the specific type of agreement that the parties enter into.

In the digital age, trust among individuals finds its manifestation through contractual agreements presented in Fig. 2. Source: Author’s own processing.

The significance of these agreements becomes most apparent when one of the parties involved in a transaction fails to adhere to the terms stipulated within the agreement. In such instances, the automatic execution of the contract is not initiated, serving to protect the rights of the party that faithfully complies with the agreed-upon terms. This mechanism ensures a level of accountability and upholds the principles of fairness within financial transactions, thereby fostering trust among the parties involved.

Consequently, the very act of conducting financial transactions is inherently rooted in the establishment and operation of financial trust mechanisms, which serve as the bedrock for ensuring the integrity of these transactions and the trustworthiness of all participating parties.

Traditional contracts

Traditional contracts, whether conveyed verbally or through written documents, typically rely on natural language for their expression. Traditionally, such contracts necessitate the involvement of a trusted third-party institution. This authoritative and reliable intermediary orchestrates and oversees the transaction, serving as a safeguard to ensure the faithful execution of the contract. Notably, in the context of contract performance, the enforcement of traditional contracts often relies on the involvement of state authorities, executed through legal coercion. A notable evolution in this process is the elimination of the need to physically transfer enforceable legal documents to an authoritative agency for execution, thanks to modern technological advancements.

From the vantage point of contract economics, the consideration of information asymmetry and the incorporation of principal–agent cost theory and transaction cost theory offer insights into the capital structure of enterprises. Each security can be viewed as a rights contract, enabling enterprises to issue specific forms of securities to resolve internal conflicts arising from rights disputes. Thus, the underpinnings of financial contract theory are grounded in the contractual relationships embedded within various securities.

Building upon financial contract theory, the classical complete contract model endeavors to endogenize the form of contracts (Eller, 2020). In contrast, the incomplete contract theory assumes the presence of contract incompleteness to some extent. The complete contract model encompasses the principal–agent model and the costly state-verification model, while the dynamic debt model falls under the category of incomplete contract models.

The complete contract model revolves around addressing the information asymmetry concerning ex-post project benefits and the associated monitoring costs for service providers (Brunjes, 2022; Gurcaylilar-Yenidogan and Erdogan, 2023). The incentive-compatible contract theory, integral to optimizing the allocation of project cash flows post-execution, emerges through the application of the “cost-state verification” methodology. For instance, Townsend (1979) utilized the OBP analysis within the complete contract theory to explore the characteristics and conditions of incentive-compatible contracts, concluding that, in the presence of ex-post monitoring costs, a firm’s optimal incentive-compatible contract for raising capital is a debt contract. Subsequently, scholars, including Douglas W. Diamond, delved into the incentive-compatible attributes of liability contracts through diverse perspectives based on the CSV analysis framework, affirming that the CSV model is characterized by singular terms, risk-neutrality among parties, deterministic verification, and the presence of a single borrower and lender.

The incomplete contract model, on the other hand, finds its foundations in the limitations of individual rationality (Gürpinar and Özveren, 2024; Loertscher and Marx, 2022). Complexity within the external environment, information asymmetry, and the inherent inability of contract parties or contract arbiters to oversee and verify every aspect culminate in the inherent incompleteness of contracts. The theory of incomplete financial contracts significantly informs research in the realm of corporate finance theory. Leveraging the concept of incomplete contracts, the theory of security design, particularly from the perspective of corporate control, represents the forefront of financial theory research.

Smart contracts

Smart contracts represent a computerized transaction protocol that operates autonomously, obviating the need for intermediaries, self-verifying and executing contract terms automatically (Lohmann, 2020). When rooted in blockchain technology, smart contracts acquire distinct characteristics, such as decentralization, trust-minimization, programmability, and immutability. They exhibit the remarkable flexibility to be seamlessly integrated into various data and asset ecosystems, fostering secure and efficient information exchange, value transfer, and asset management. This technological innovation is poised to usher in profound transformations within traditional business and financial models, redefining social production relations. It also serves as the bedrock for the creation of programmable assets, systems, and societies.

Smart contract technology is an integral component of blockchain technology, serving as a form of contract tailored to the realm of multiparty Internet-based transactions. In essence, it embodies a computable transaction agreement throughout the execution of contract terms, signifying a shift from traditional transaction systems to a digital paradigm. Notably, Ethereum’s smart contracts, based on blockchain technology, have garnered widespread acclaim. In a narrower sense, they encapsulate business logic and algorithms, enabling the integration of network, human, and legal elements. In a broader context, smart contracts operate as intelligent computer protocols, capable of self-execution and verification. They find applications across diverse sectors, including the burgeoning landscape of the Internet of Things and various industries.

Just like conventional contracts, smart contract technology adheres to a full lifecycle principle, encompassing three key phases: contract creation, deployment, and execution. During the creation phase, the contract’s specifications and specific verification criteria are automatically generated through negotiations involving multiple parties. Once the fundamental contract standards are established, the contract code is formulated following meticulous verification. Contract validation requires individuals possessing pertinent expertise to conduct initial negotiation checks, or alternatively, virtual validation can be conducted through the system’s abstract model. Ensuring the alignment of contract code and contract text is pivotal to ensuring the security and stability of contract execution. In the deployment phase, akin to the release of specific transactions, signed contracts are distributed directly across the P2P network. Subsequently, each node receives the contract, stores it within its consensus system, aggregates recently received contract systems to compute the hash value of the set, and shares it with other nodes in the network. Upon receipt, each node compares the value with its own calculation, forging a consensus that ensures the dependable execution of the contract.

Blockchain technology, as a catalyst for innovation within financial institutions, can effectively address numerous challenges associated with equitable trade and securities. Specific platforms, such as Ethereum, have showcased pronounced advantages in the realm of financial transactions. They not only address security and contract contradictions inherent in public chains, facilitating programmatic management, but they also cater to diverse usage requirements, capitalizing on their synergistic capabilities. On the other hand, Hyperledger Fabric aptly handles transaction-related issues within consortium chains. The recent update has seen many financial institutions favoring Fabric, with domestic banks also adopting the model to construct consortium chains, thereby establishing blockchain-based business innovation ecosystems. Diverse platforms offer their unique benefits, primarily focusing on enhancing privacy and security within financial transactions, along with expanding platforms and business models (Hypotheses 1.1-2.2).